When I do PowerPoint presentations on monetary policy, I often explain level targeting with an analogy from the oil industry. Suppose oil output was suddenly reduced by technical problems in Saudi Arabia, but the disruption was expected to be temporary. In that case, oil prices would rise by much less than if the exact same reduction is supply was expected to be permanent.
If oil production declines for only a brief period, the producer can commit to restoring oil prices to their target level after the problems are fixed. That commitment will tend to prevent prices from rising very much, even during a period of supply disruption. If the normal price were $50/barrel, then a rise to $53 might lead wholesalers to release oil from their inventory, with the expectation that they’d later restock at lower oil prices after production was restored. Here the key assumption is that the “swing producer” has a credible commitment to maintain stable oil prices in the long run.
I use this example because something very similar occurs with level targeting. If the central bank is credibly targeting gold or foreign exchange prices, then a temporary shock will have little impact, as traders know that prices will soon return to the target range.
And this explains why NGDP level targeting is so desirable. Under level targeting, a temporarily disruption like Brexit, or a trade war, has little impact on NGDP due to the central bank’s commitment to eventually return nominal spending to the target path. Strong expected future growth keeps companies from abandoning projects during a period of temporarily depressed demand. It creates what Keynes called “animal spirits”. As a result, demand doesn’t fall by as much, even in the short run.
But does this “expectations fairy” actually work? The recent Saudi oil shock suggests that the answer is yes. On September 16 of this year, attacks on Saudi oil infrastructure temporarily cut production roughly in half. Normally, that would cause a huge spike in prices, as the demand for oil is pretty inelastic. And prices did surge on the 16th, along with reports that the damage might take “weeks” or “months” to fix.
Soon after, it became apparent that the disruption would not last as long as many feared, and oil prices almost immediately fell back by $5 barrel. Thus the price increase ended up being much smaller than the initial shock, because investors understood that inventories could meet demand during the repair period, and that once oil production was restored the Saudis would be able to ramp up production and normalize the market.
Under level targeting, it’s important to try to get NGDP back to the trend line as soon as possible. It would do no good today to try to restore NGDP to the pre-2008 trend line—too much time has gone by. Instead, central banks should promise that if there is a recession in 2020, they will do whatever it takes to get the price level (or better yet NGDP) back up to trend by 2022. That promise will make any recession much milder, even if monetary policy were powerless during the recession itself. (And it isn’t powerless.)
PS. President Trump has recently called for zero interest rates. Although I understand the logic of his argument, I believe he’s making a mistake. Zero interest rates are likely to occur if there is very weak NGDP growth. Instead, he should be calling for a monetary policy that will generate a healthy economy without the need for zero interest rates. He should call for level targeting.
READER COMMENTS
stoneybatter
Oct 3 2019 at 4:31pm
Good post.
Check out the prices on the 12th-month WTI contracts, i.e the ones for delivery in October 2020 (or CL12 Comdty). Whereas the front-month contracts that you cited rose 15% after the Saudi attack, the 12th-month contracts increased just 6%. Even during the initial, panicky phase of your narrative, markets still efficiently priced the temporary nature of the shock.
Wouldn’t it be nice if NGDP expectations one year into the future were equally immune from temporary shocks?
IVV
Oct 3 2019 at 4:37pm
I just thought Trump wanted his partners to borrow from the US government at no interest. Preferably indefinitely.
Thaomas
Oct 3 2019 at 6:10pm
I guess if we really really believed that this time the Fed really really had a price level trend or NGDP target from now on, that could be optimal. But we have seen no evidence that it does and no evidence that it does not even now have an inflation ceiling. [How many times should Charlie Brown believe Lucy will not move the football?]
Wouldn’t it be better for the Fed to announce that it has such a level trend target from a few years ago, long enough back to allow markets to observe them from the time of the announcement moving its instruments — Fed funds rates, QE, IOR, foreign exchange market interventions or whatever else they might think up — to achieve the target and then stopping when it was achieved?
On the oil market, would it not be a more relevant analogy if the shock were lower demand for an uncertainly temporary period? Brexit and the war on trade are demand shocks, not supply shocks.
Lorenzo from Oz
Oct 3 2019 at 8:29pm
Nice vivid example.
How to distinguish the developed economies that went into The Great Recession from those who stayed in The Great Moderation:
The former anchored expectations on inflation but not spending. The later anchored expectations on inflation AND spending. So transactions crashed in the first group but not in the second.
LK Beland
Oct 4 2019 at 1:44pm
To borrow from a famous Keynesian economist, “the central bank needs to credibly promise to be irresponsible”. Level targeting is such a promise.
P Burgos
Oct 5 2019 at 9:26pm
Level targeting is also implicitly a kind of promise to politicians that if they make bad economic policy, the result will be elevated unemployment and higher inflation. I don’t have a lot of faith that politicians in the US would figure out how to live with this, as opposed to trying to undo NGDLT.
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